Life Insurance Considerations
for Legal and Tax Professionals
CPAs • Attorneys • Enrolled Agents • Tax Professionals
Professional Education NetworkTM
Contents
1 Introduction
1 Basics of Life Insurance
3 Insurance Planning Steps
4 Types of Life Insurance
7 Ownership Considerations
9 Cash Loans versus Cash Withdrawals
10 Beneficiary Designations
1 1 Policy Replacement Considerations
12 Company Ratings and State Regulations
13 Conclusion
13 How Edward Jones Can Help
Introduction
Trusted legal and tax advisors may find that their clients ask about life insurance. This brochure
provides an introduction to some common life insurance terms, discusses the basic insurance
planning process and explores its use within clients’ overall financial strategies.
No one wants to consider his or her own mortality.
However, people should not ignore the impact
their deaths can have on those they leave behind.
By understanding the facts about life insurance,
professionals can help their clients make informed
choices about how best to financially protect
and provide for those who matter most to them.
Buying life insurance is a multifaceted decision
for a client: Which type of policy should I
choose? How much coverage and for how long?
What premium level fits my budget? Choosing
insurance is not just a financial decision; it can be
an emotional decision as well: How will my spouse
pay the mortgage if I die? Will my children be able
to go to college? What will happen to my business?
Basics of Life Insurance
Life insurance is a financial resource that can be used to help protect families in case a spouse
dies and businesses in case an owner or a key employee dies. It can also help with planning
a financial legacy. It is a contract between a policyholder and an insurance company in which
the insurer agrees to pay the contracted amount to the beneficiary or beneficiaries upon
the death of the insured.
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Policyholders pay premiums to maintain
coverage, either over a specified period
of time or over their lifetimes. How much
premium a policyholder pays depends on the
insured’s age, gender, occupation, hobbies,
tobacco use, medical history, foreign travel or
residence, type of policy and coverage amount.
Life Insurance Can Help Individuals
with Long-term and Legacy Goals
While the primary purpose of life insurance is
financial protection, it can also be used to help
accumulate funds to cover long-term financial
goals such as the following:
Life Insurance Can Help Protect
a Family’s Financial Security
•
Supplemental income for retirement –
A permanent policy’s cash value can
supplement retirement income received
from other sources. Through carefully
planned loans and withdrawals, the funds
may be received on a nontaxable basis.
•
Building wealth for tax-efficient transfer
to heirs – Life insurance can serve as an
estate-planning vehicle, allowing proceeds
to be paid directly to beneficiaries, bypassing
the probate process. Life insurance can be
used as an efficient wealth transfer vehicle
because death benefits are generally paid
income tax free to beneficiaries.
•
Liquidity for large estates – For clients
with large estates, life insurance can provide
liquidity to pay federal and state estate taxes,
state inheritance taxes, attorney fees and
probate expenses.
•
Business planning – If a client owns a business,
life insurance policies can help protect the
business in the event of the client’s death. For
example, insurance can indemnify a business
for the loss of earnings caused by the death
of an owner or a key employee. It can also
fund a buy/sell agreement between owners
of a business, which allows the surviving owner
to purchase the deceased owner’s portion
of the business. Additionally, life insurance
can be used to provide executive benefits
to key employees and enhance a business’s
ability to secure credit.
•
Gifts to charity – Life insurance can provide
money for a charity, a religious organization
or an educational institution, or it can replace
assets bequeathed to charity.
Life insurance offers much-needed financial
security. It can provide:
•
Funds to cover final expenses – Proceeds
from a life insurance policy can be used to
cover funeral expenses, estate-processing
fees, outstanding medical bills and other
unpaid debts.
•
Income during the readjustment period –
Surviving family members need time, usually
two to three years, to adjust financially to the
loss of the insured’s income. The surviving
spouse may need to acquire new skills to
rejoin the workforce.
•
Income for the surviving spouse – Life
insurance can provide the surviving spouse
financial support for a certain number
of years or for life.
•
Income for dependent children – Funds from
a policy can support a policyholder’s children
until they become financially independent.
Life insurance also can provide funds for
college or private school education costs,
or help meet the financial needs of physically
or developmentally disabled children.
•
Funds to pay off the mortgage – Proceeds
from the policy can be used to pay off
a mortgage, thereby alleviating some
of the financial pressure on the family.
Without life insurance, survivors may have to
sell assets, such as a home, to pay expenses.
With life insurance, the beneficiaries may have
the financial resources they need at the time
of the insured’s death.
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Insurance Planning Steps
The first step is to determine a client’s financial goals, whether planning retirement or their
estate, and discuss how life insurance may play a role in helping to reach these goals. The client
and his or her financial advisor and tax or legal professionals can then complete a needs analysis
to determine how much life insurance coverage may be needed to help provide for family
or business financial needs based on those goals.
Performing a needs analysis can help determine
the amount of life insurance that might be
appropriate and make informed choices about
how to provide for legacy goals or help protect
loved ones in the event of an untimely death.
To determine which policy or policies would
be appropriate, several factors are considered,
including the appropriate coverage amount, the
length of time the policy is needed, the premium
amount that fits the client’s budget, desired
flexibility and the client’s risk tolerance.
When the primary objective may be time-specific
or a non-legacy goal, the following approaches
may be considered to help determine the
potential amount of insurance to consider:
How Much Life Insurance
May Be Appropriate?
There’s no magic formula for determining how
much life insurance to buy, because no two people
have the same needs or circumstances. The
insurance needs of a single parent can vary greatly
from those of someone supporting an elderly parent
or those of a business owner planning succession.
•
Multiple of income approach: Calculate seven
to 10 times the client’s pretax annual salary.
•
Needs approach: Estimate the client’s family
expenses and savings needs over time using
the acronym LIFE.
Use LIFE as a Guide
Add the following together to estimate life insurance needs:
L
Liabilities (like mortgage, car loans, credit cards, etc.)
I
Income needs for the client’s family to replace future salary and cover ongoing living expenses,
saving needs and an “emergency” fund
F
Final expenses
E
Education expenses for the client’s child(ren)
Importantly, the LIFE framework does not include
any potential legacy goals such as leaving a lump
sum to heirs or charity. This objective may be
added to LIFE, so the client’s total life insurance
needs would be "LIFE and legacy."
Since the key is to have a strategy to provide for
the client’s family, either approach can provide
a solid estimate of potential insurance needs.
Planning Tip
Edward Jones financial advisors provide a valuable resource to help analyze insurance needs and options
for you and your clients. To learn more, please contact an Edward Jones financial advisor.
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Types of Life Insurance
Life insurance can be divided into two types: term and permanent. Within these two types
are subcategories. Clients should choose the policy that best meets their goals based on the
amount of time the insurance may be needed. This is not an either/or decision. For example,
the LIFE framework may be providing cash for a time-specific need, which may be satisfied
with term life insurance, while legacy goals, which may be desired to pay at death regardless
of the time period, may be better satisfied by permanent life insurance.
understand the client’s life insurance needs and
objectives before recommending any specific
type of life insurance policy. The following chart
is designed to help determine the right type of
life insurance based on a client’s potential needs:
What Type of Life Insurance
Is Right for My Client?
Many considerations must be taken into account
when determining the appropriate life insurance
contract for a client. It is important to fully
Evaluating Life Insurance Options
START
Term Insurance
• For clients who
need coverage
for 20 years
or fewer
• For clients who
Term and Permanent Blend
Permanent Insurance
• For clients who need coverage
• For clients who need
for more than 20 years
• For clients who are on a somewhat
limited budget but need permanent
coverage for more
than 20 years
• For clients who are
insurance, a permanent policy
adequately saving
are on a limited
can be supplemented with some
and investing and have
budget
term insurance.
some budget flexibility
No-lapse Variable
Variable Universal Life
Universal Life
Universal Life or Whole Life
• Client is willing to assume
• Client wants fixed premiums
and a guaranteed death benefit.
• Client prefers a more
market risk to achieve
stable policy with potential
greater returns.
for cash value growth.
is covered for a specific term or time frame, such
as 10, 15, 20 or 30 years, and benefits are paid
only if he or she dies during this time period.
If premium payments stop, coverage ceases.
Term Life Insurance
Term life insurance is the most basic type of life
insurance and usually offers an affordable, level
premium for a fixed number of years. The insured
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Premiums are based on the insured’s age, gender,
tobacco use and health, and the coverage amount
requested. Premiums on some annually renewable
term policies increase with age.
Permanent Life Insurance
Permanent life insurance provides protection
for the policyholder’s entire lifetime rather
than a specific time period, as long as premium
requirements are met. In addition, permanent
insurance builds cash value. These dollars
generally are used to pay the higher cost of
insurance as a person ages, without increasing
the annual premium. The accumulated cash value
can be accessed through loans or withdrawals
and used to fund future goals, such as college
education costs or supplemental retirement
income. However, using cash value to cover
other expenses could affect the policy’s ability
to provide for the life insurance need.
Term insurance is typically purchased by people
with short-term life insurance needs (usually 20
years or fewer) or by those with longer-term
needs who, for budget reasons, need relatively
inexpensive coverage. Many term life insurance
policies can be converted to permanent policies
issued by the same insurance company without
providing additional medical information, but the
conversion period may be limited. Consequently,
it's important to understand the policy options
when purchasing a life insurance contract.
Permanent policies also typically enjoy favorable
tax treatment because the cash value growth
is usually tax-deferred. Individuals and smallbusiness owners typically purchase permanent
insurance if they have long-term life insurance
needs and can afford premiums that are higher
than those of term life.
Following are some reasons term insurance may
not be the better choice for long-term needs:
•
Term insurance may reach a point where
the client cannot afford to pay an increasing
premium.
•
If a term policy is kept long term, the cumulative
increasing premiums can exceed the rate the
client would have originally paid for a level
premium permanent policy.
•
Types of Permanent Life Insurance
Whole Life Insurance
If the insured of a level premium term policy
outlives the policy’s time frame and his
or her health has deteriorated, the premium
will increase significantly at renewal time.
The insured may be unable to purchase
a different policy to avoid higher premiums.
Whole life is a type of permanent insurance
suitable for an individual who wants guarantees in
his or her contract. Whole life contracts guarantee
minimum cash values, level premiums and death
benefits, as long as premiums are paid on time.
Because of the guarantees, for which the
insurance company assumes all the risks, whole
life carries the highest premium of all types of
permanent insurance. This type of policy is also
the least flexible. For example, the insured cannot
increase his or her coverage within the same
contract. All whole life policies are structured
to endow, meaning the cash value will equal
the policy death benefit at policy maturity,
typically at age 95 or 100.
A variation of term life insurance is group term
life insurance. Generally, group term coverage is
available on a guaranteed issue basis (no medical
underwriting) through an employer-sponsored,
employer-paid plan with limited coverage
amounts (usually no more than $50,000 per
person) for employee participants. The employer
maintains the master policy for the group. State
laws generally require that the employer furnish
the employee with a certificate of coverage
in writing or electronically.
Some whole life insurance policies pay the
policyholder an annual dividend representing
a return of unused premium. Policy dividends
can be taken tax free in cash, applied toward
premiums, used to purchase additional paid-up
death benefit coverage inside the whole life
policy or reinvested inside the policy for interest.
Many group term life plans contain a conversion
privilege allowing employees to convert their
coverage to an individual universal life policy
within 30 days after separation of service due to
retirement or departure for employment elsewhere.
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Universal Life Insurance
Variable Life Insurance
Universal life is a type of permanent insurance
typically more suitable for an individual who
wants fewer guarantees and more flexibility. The
premium, cash value and death benefit are not
guaranteed, even if the premium is paid on time.
The policyholder assumes almost all of the risks.
Because there are few guarantees in the contract,
the premium is lower compared to whole life. The
flexibility that was lacking in whole life is available
for universal life. For example, increasing or
decreasing the face amount of the policy will cause
the premiums to increase or decrease accordingly.
Variable whole life and variable universal life
are similar to whole life and universal life except
that a portion of the annual premium is used to
fund cash value growth in variable subaccounts
chosen by the client from a predetermined list
of stock, bond and mutual fund portfolios. These
products are subject to extensive federal and
state securities regulations requiring the client
to complete a suitability questionnaire and be
provided by his or her financial advisor with a
current prospectus on the investment history of
the variable insurance product being purchased.
Some universal life policies offer what is referred
to as an Option A or Option B death benefit.
Under Option A, the policyholder chooses a
policy that has a level death benefit with a higher
cash value. Under Option B, the policyholder can
choose a higher death benefit equal to the sum
of the policy’s face coverage and the policy’s
cash value.
Because these products carry market risk,
variable life is typically more suitable for clients
comfortable with the risks inherent in equities.
Variable insurance products may not be as suitable
for older clients because of their shorter time
horizon and potentially lower ability to handle
market risk.
If the financial condition of the insurance company
deteriorates, the expenses it charges against the
policy’s cash value can increase. Higher expenses
can drain the cash value. If this happens, the policy
may lapse or premiums may increase.
A modified endowment contract (MEC) is not a
type of life insurance. Instead, it is a type of policy.
MECs are generally single-premium contracts
purchased on or after June 21, 1988. However, an
MEC can be any policy that has exceeded stated
IRS guidelines for the maximum premiums that can
be paid during the first seven policy years. Almost
all single-premium policies are considered MECs.
Modified Endowment Contracts
An insurance company will guarantee payment
of only a minimum interest rate on a contract.
However, a contract is usually credited by the
insurance company with a current-year interest
rate based on an intermediate-range bond
rate being paid inside the insurance carrier’s
investment portfolio. Clients should be aware
that if the current interest rate being credited
decreases, additional premiums may be required
to keep the policy in force.
During the insured’s lifetime, any policy classified
as an MEC is treated similarly for tax purposes
to an annuity (IRC 7702A). This results in the
following:
No-lapse Guaranteed Universal Life Insurance
No-lapse guaranteed universal life insurance
has the same features as universal life. However,
as long as the premium is paid on time, the
policy is guaranteed not to lapse. Compared to
universal life, this type of no-lapse policy trades
off noticeably lower cash value accumulation
in exchange for a guaranteed death benefit
and guaranteed level premiums.
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•
Any loans or withdrawals are taxable as
ordinary income on a last in, first out (LIFO)
basis; i.e., gains above cost basis are taxed first.
•
Pledging a cash-rich MEC policy as security
for a loan can result in an immediate tax event
to the policyholder. A limited exception may
apply when the pledge is restricted to the
payment of burial or prearranged funeral
expenses, but only if the policy’s maximum
death benefit does not exceed $25,000.
•
Withdrawals and loans made prior to age 59½
are usually subject to a 10% federal tax penalty.
Several differences between MECs and annuities
are as follows:
•
gain in the contract is generally taxable
to the beneficiary as ordinary income.
Upon the death of the insured, the MEC policy
is still treated as life insurance. This means the
death benefit received by a beneficiary such as
the surviving spouse is almost always free from
income tax. This is different from an annuity
where, upon the policyholder’s death, any
•
In life insurance, the person insured is called
the “insured.” In an annuity, the person insured
is called the “annuitant.”
•
Life insurance is generally purchased for
the death benefit. An annuity is purchased
to provide a retirement benefit and protection
against outliving one’s retirement income.
Ownership Considerations
The ownership of life insurance is an important matter. If an individual who is both the owner
and the insured of a life insurance policy dies, the death benefit is part of his or her estate.
Thus, the death benefit could be subject to estate taxes if the individual’s net worth exceeds
the federal and/or state exemption amounts.
If someone other than the insured owns the
policy from the date it is issued, and if the insured
does not hold any other incident of ownership
in the policy, the death benefit is not included in
the insured’s estate when he or she dies. Typical
examples of owners other than the insured are
the insured’s adult children or an irrevocable life
insurance trust.
Incidents of Ownership
The death benefit is included in an estate if the
decedent is listed as the owner, was the applicant
on a policy on his or her own life, or had certain
types of control over the disposition of the policy.
If the insured has certain incidents of ownership in
a life insurance policy, it may be includable in his
or her estate for estate tax purposes. Incidents of
ownership are not limited to actual ownership of
the policy and include other ways that the insured
or the insured’s estate has control over the policy
or the right to the economic benefits of the policy.
Incidents of ownership include the following:
•
•
The power to name or change the beneficiary
•
•
The right to surrender or cancel the policy
Below are some potential pitfalls in having adult
children own the insured’s life insurance policy:
The right to assign the ownership of the policy
to another person or revoke that assignment
The right to borrow money from the policy
or pledge the policy as collateral for a loan
It is important to note that, under IRS rules,
should the owner of a life insurance policy transfer
ownership within three years before his or her
death, the policy’s death benefit may be included
in the deceased’s estate and be subject to estate
tax. This rule may not apply when policy ownership
is transferred between spouses.
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•
If the adult child divorces, the policy ownership
or cash value could be awarded to the spouse
in a division of property by a state divorce
court judge.
•
If the adult child declares a Chapter 7 or
Chapter 13 bankruptcy, creditors could attach
the policy in federal court proceedings where
cash values in life insurance contracts are only
protected for debtors up to a limited amount.
•
If the adult child is sued, the policy might
be attached in state civil court proceedings.
State laws vary widely regarding the amount
of the cash value and death benefit of a policy
that may be exempt from creditor claims.
In determining whether and to what extent
a policy can be protected from creditors,
many state laws consider whether the policy
is owned by a debtor who is the sole provider
the owner and the beneficiary of the policy on
the life of the grantor (insured person). An ILIT
is an inter vivos trust (one created during the
grantor’s lifetime) that is structured to be exempt
from estate tax. An additional benefit of an ILIT
is that the trust receives the death benefit in cash
upon the death of the grantor. Often, the grantor’s
estate must pay estate tax, but holds mostly illiquid
assets such as real estate or a small business. The
ILIT can purchase assets from the grantor’s estate
to provide liquidity for the amount of estimated
estate taxes due upon the grantor’s death.
of support for a household or whether
substantial premiums are being paid
by the debtor to defraud creditors.
•
If adult children are under financial strain
and decide they need cash, they could access
the policy for that cash and thereby cause
the coverage to lapse due to excessive loans
or withdrawals.
As an alternative, an insurance policy can be
owned not by children but by the trustee of an
irrevocable trust. An important advantage of
naming a trustee as the life insurance policyholder
is that the trustee will be better suited to withstand
creditor collection challenges in federal or state
courts, and can prevent a beneficiary’s detrimental
use of the policy cash value. Drawbacks to using
a trust include the cost of establishing the trust
and annual administration fees. Life insurance
trusts are discussed in more detail below.
Almost any type of policy insuring the grantor’s life
may be used to fund an ILIT, such as life insurance
on the life of one person or a survivorship policy on
the lives of two people (usually a married couple).
Permanent cash value policies with guaranteed
level premiums and face coverage amounts can
often accomplish the desired purpose of an ILIT.
Although an ILIT can be funded by a term life
insurance policy to contain costs, if the insured is
likely to outlive the policy’s time frame (typically
20 years), it may be more cost-effective over
time to fund the ILIT with a permanent policy.
After the term has expired, the trust’s premium
for policy renewal will be significantly higher
due to the insured’s increased age. Converting
to a permanent policy at this later date will result
in higher premiums than would be applicable
if a permanent policy had been arranged earlier.
In certain situations, permanent cash value life
insurance may be owned by an administrator inside
a qualified retirement plan, such as a 401(k). In this
situation, the life insurance policy cash value may
be exempt from creditor collection efforts, except
for certain creditor processes such as IRS tax liens
or a qualified domestic relations order entered by
a state court in a divorce proceeding.
To determine the best choice for life insurance
ownership based on business, personal or estateplanning considerations, a client should discuss
the matter with his or her legal and tax advisors.
It should be noted that the grantor of an ILIT does
not have control over the contract and cannot
serve as trustee or co-trustee of the ILIT. Instead,
the grantor names an individual (who could be
the grantor’s spouse or other family member),
commercial bank or corporate trust company to
serve as trustee of the ILIT. The ILIT is then named
as owner and beneficiary of the insurance policy,
thereby keeping the policy proceeds out of the
grantor’s taxable estate.
If a client owns a life insurance policy on a
third party, such as a parent, spouse or child,
consideration should be given to naming a
successor owner, should the client die. By doing
so, potential disputes over policy ownership,
including lengthy probate proceedings, may
be avoided.
It is important to know that when the owner
of a life insurance policy is not the insured,
only the owner has control of the contract.
The insured has no rights in the policy.
To provide the trust with the necessary funds
to pay premiums on a life insurance policy, the
grantor may generally gift the annual gift exclusion
amount per year per trust beneficiary. Beneficiaries
are typically family members or loved ones.
Irrevocable Life Insurance Trust
To ensure that the annual gift per beneficiary
qualifies for the annual exclusion from gift tax,
Life insurance may be used to fund an irrevocable
life insurance trust (ILIT) where the trust is both
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each trust beneficiary is granted a limited right,
called a Crummey right, to withdraw the gift made
to the ILIT. Once money is paid into the trust to
pay the annual life insurance premiums, the trustee
must provide written notice to the beneficiaries
of their right to withdraw the gift made on their
behalf. In general, beneficiaries are given 30 to 60
days’ notice to exercise this right. After this time
period has expired, the trustee may pay the life
insurance premiums.
The grantor may decide not to use the annual gift
exclusion giving his or her beneficiaries Crummey
withdrawal powers. Instead, the grantor may utilize
his or her ability to make a single gift to the trust
up to the maximum federal lifetime exemption to
pay for a single-premium policy with a guaranteed
death benefit and minimal cash value.
Planning Tip
Many states impose an estate tax on a person’s assets after death, an inheritance tax on heirs receiving such
assets, or both. In addition, few states follow the federal portability rules whereby a surviving spouse can carry
over the portion of the deceased spouse’s exemption from estate tax, so married individuals may still need to
establish trusts to obtain the benefit of two exemptions under state law. Legal and tax advisors should follow
federal and state legislation on this issue closely if assisting clients with one-time gifting concerns.
Cash Loans versus Cash Withdrawals
It is important to understand the consequences of taking a loan versus a withdrawal from
a life insurance policy.
insurance company to pay premiums from
the policy’s cash value if the premium is not
paid within 30 days after the premium due
date. Premium loans are assessed either
a fixed or variable loan rate. Premiums paid
in this manner over an extended period of time
can result in lapse of coverage when the loans
and interest exhaust the policy’s cash value.
In this type of policy lapse situation, excessive
unpaid loans and loan interest may cause the
policyholder to incur an income tax liability.
Loans
If a policyholder makes a loan against his or
her policy and repays the loan during his or her
lifetime, the death benefit remains unaffected. If
the insured dies while a loan is outstanding, the
insurance company subtracts the loan balance
plus any unpaid loan interest, dollar for dollar,
from the death benefit paid to the beneficiary.
Interest charged on policy loans is calculated
in one of two ways, based on life insurance
policy provisions:
•
A fixed interest rate, not to exceed
8% per annum
•
A variable interest rate tied to Moody’s
Corporate Bond Yield Index, often
recalculated on a monthly basis
The repayment of interest on a policy loan
may not be a deductible expense for tax
reporting purposes.
Withdrawals
When a substantial withdrawal is made, e.g.,
a cash withdrawal that exceeds cost basis, it
could have a negative tax consequence. Per IRS
Most permanent life insurance policies have
an automatic loan provision that allows the
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rules, anytime a cash distribution from a policy
results in a reduction of the death benefit within
the policy’s first 15 years, some portion of the
distribution may be subject to income tax.
In most cases, a policyholder is better off taking
a loan rather than a withdrawal from his or her
insurance policy. A loan can be repaid during
the insured’s lifetime to prevent a reduction of
the death benefit paid at the time of the claim.
Beneficiary Designations
When a client buys life insurance, he or she must name a beneficiary. At the time of purchase,
the beneficiary must have an insurable interest. This means that if the insured were to die,
the beneficiary would experience a financial loss.
The insured should also keep in mind that he
or she may outlive a named beneficiary, so
one or more contingent beneficiaries should
be named to provide for this potential event.
Insurance companies are generally unwilling
to agree to a beneficiary designation on a new
policy where no insurable interest exists. Once
a policy is issued, the owner can change the
beneficiary designation to anyone he or she
wants without obtaining the approval of the
insurance company.
Although beneficiaries of life insurance policies
are generally entitled to receive the death benefit
proceeds gift and income tax free, in some
situations, such as the two described below,
improper policy ownership and beneficiary
designation arrangements can have potentially
negative tax consequences to the beneficiaries.
Beneficiary designations can be revocable or
irrevocable. The owner can change a revocable
beneficiary at any time. An owner cannot remove
an irrevocable beneficiary unless the beneficiary
consents to such a change in writing.
Example One
Joe Smith owns a business. He buys a $3 million life insurance policy on himself with the business owning
the policy and paying the premiums. Joe names his wife, Mary Smith, and the couple’s three adult children
as equal beneficiaries. Upon Joe’s death, the policy pays a death benefit of $750,000 to each beneficiary,
which subjects the survivors to gift taxes. Because the policy is owned by Joe’s business, rather than Joe
himself, the IRS may deem the policy premiums as being a taxable gift from the business to Joe’s spouse
and children.
Example Two
Joe Smith wants to insure his life for $3 million in order to leave a large sum to his oldest son, Jerry.
Jerry purchases the policy on his father and is the owner. Jerry wants to be fair to his siblings, so he names
himself and his two younger brothers, James and John, as equal beneficiaries on the policy. Upon Joe’s
death, the $3 million death benefit is paid in equal shares to Jerry, James and John. Because Jerry is
the owner of the life insurance policy, however, the IRS may deem that Jerry has made a taxable gift
of $2 million to his brothers when the death benefit is paid.
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Policy Replacement Considerations
Replacing a permanent life insurance policy with a new one may not be in the policyholder’s
best interest.
Following are a few issues to consider when
replacing permanent life insurance:
•
•
1035 Exchanges
A 1035 exchange enables a policyholder to
exchange permanent cash value contracts while
deferring any taxable gain. A 1035 exchange
can be processed on the following:
The new insurance company can challenge
a death benefit claim that is filed within two
years from the date of policy issue. (State
guidelines should be reviewed; some states
differ regarding this general rule.)
The insured may lose a lower policy loan interest
rate or forfeit other favorable policy provisions,
such as those that provide for a premium waiver
in the event of disability, an accelerated death
benefit for terminal illness or long-term care
needs, or an additional purchase option allowing
the insured to increase his or her coverage
without further medical underwriting.
•
The insured may lose important grandfathered
rights, such as attractive loan features, including
the ability to borrow on a first in, first out basis
for a non-MEC policy.
•
A new surrender penalty schedule can apply
for up to 15 years.
•
There may be fewer contractual guarantees,
such as the loss of a guaranteed death benefit
or guaranteed level premium.
•
A life insurance policy exchanged
for another life insurance policy
•
A life insurance policy exchanged
for an annuity
•
•
An annuity exchanged for another annuity
•
A permanent life insurance policy or annuity
for a qualified long-term care insurance policy
An endowment life contract exchanged for
an annuity, if done before the endowment date
A 1035 exchange cannot be processed on the
following:
•
•
An annuity to a life insurance policy
An endowment life contract to any life insurance
contract other than another endowment of the
same endowment date
In addition, a 1035 exchange can generally occur
only if the new and the existing contracts have
the same policyholders and insureds (or annuitants
in the case of an annuity). For example, a policy
owned by Joe Smith with Mary Smith as the
insured may be used as a 1035 exchange only
for a new policy owned by Joe Smith with
Mary Smith as the insured or annuitant.
Other factors to consider include the following:
•
•
If the insured is in poor health, he or she may
be giving up a contract with a more favorable
medical rating. If the existing contract has
a medical rating, the insured should probably
keep the current contract unless his or her
health situation has improved substantially.
An exchange of multiple policies to one new policy
normally qualifies as a 1035 exchange as long
as the policyholder and insured are the same
on both the existing and the new contracts
and the exchange is initiated at the same time.
If the existing contract has a very large
surrender penalty, other options within the
existing policy should be considered before
replacement, depending on the client’s
objectives.
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a less favorable interest rate on the new policy.
Therefore, it is extremely important to consider
all consequences before making changes.
Exchanging Single Life Policies
for Multiple Life Policies
The exchange of a single-owner, single-insured
policy for a first-to-die or second-to-die policy,
commonly called a “survivorship life” policy
and used for estate-planning purposes, does
not qualify as a 1035 exchange because the
owner and insured are not the same on both
the existing and new contracts.
If a policyholder uses his or her policy cash value
to extinguish a loan as part of a 1035 exchange,
the policyholder may recognize taxable gain in
purchasing a new policy with no debt. The IRS
may not view this 1035 exchange as triggering
an income tax event if the loan on the policy being
replaced is paid off from outside (non-policy)
funds that originate from a savings account, a
checking account or some other financial resource.
Exchanging Life Insurance Policies
with Loans
It is important to be very careful when considering
replacing or exchanging an existing policy with
a loan, as doing so could cause tax consequences.
If the client’s goal is to eliminate the policy loan by
exchanging to another life insurance contract or an
annuity, the loan amount may have taxable “boot”
consequences. In other words, the loan amount
could be taxed as ordinary income to the extent
of gain represented, i.e., taxed on a LIFO basis.
Gifting Life Insurance Policies
with Loans
The IRS may treat the gift of a life insurance
policy subject to an outstanding policy loan
as part sale and part gift transaction. The value
of the loan is treated as consideration received
from the donee (the “sale” portion). The net
cash surrender value is deemed to be the “gift”
portion. If the value of the loan on the date of
the gift is less than the donor’s basis, the donor
will not recognize any gain on the transfer of
the policy. However, if the loan balance is greater
than basis, gain will be recognized to the extent
that the loan exceeds basis.
On life-insurance-to-life-insurance replacements,
some insurance companies allow the loan on
the existing contract to transfer to the new
contract where the outcome results in no taxable
event to the policyholder because no gain is
recognized. However, the client may end up with
Company Ratings and State Regulations
A life insurance policy or an annuity is only as secure as the insurance company issuing it.
Hundreds of life insurance companies do business in the United States. These life insurance
companies are rated on a regular basis for purposes of assessing their financial soundness with
respect to maintaining profitability, managing investment assets and retaining cash reserves
to pay policy claims and other related liabilities when they become due.
of the insurance companies from which they
have purchased some type of insurance product.
The major financial ratings services for the life
insurance industry are A.M. Best, Standard &
Poor’s, Moody’s Investors Service and Weiss
Ratings. It is important to remind clients to be
aware of any significant changes in the ratings
State insurance regulations impose strict financial
and legal operating requirements on life insurance
companies. If a life insurance company cannot
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limits vary by state, but most states offer at least
the following1:
meet these requirements because it is under
financial distress, a state insurance regulator
can step in and suspend its sales operations
to issue new policies or liquidate the company
in the event of extreme insolvency.
In order to provide some level of financial
protection to the general public, each state
maintains a life and health guaranty association
where insurance companies licensed to do
business in that state are charged an assessment
for monies held in trust by the State Insurance
Director for the benefit of policyholders should
any insurance company become insolvent. These
guaranty associations provide only minimal
protection to policyholders. Maximum benefit
•
$300,000 maximum coverage for pending
life insurance death benefit claims
•
$100,000 maximum coverage for life insurance
cash surrender or withdrawal values
•
$250,000 maximum coverage for present
values of annuity benefits, including net
cash surrender and withdrawal values
•
$300,000 maximum coverage for any
combination of the above
1
National Organization of Life and Health Insurance Guaranty
Associations: www.nolhga.com/policyholderinfo/main.cfm/
location/questions
Conclusion
Life insurance can fulfill a variety of purposes in helping to protect a family’s financial security
or funding a legacy goal. It can provide funds to cover final expenses, income during the
readjustment period, income for a surviving spouse and dependent children, funds to pay off
a mortgage, liquidity for large estates, tax-efficient transfer of wealth to heirs and assistance
with business succession concerns.
How Edward Jones Can Help
Edward Jones is committed to helping clients meet their financial goals using a team approach.
An Edward Jones financial advisor can walk you and your clients through the process of
evaluating the wide range of insurance options we offer and selecting the products that
best fit their needs. Working together, we can assist mutual clients in making cost-effective,
intelligent choices to address their personal, business and estate-planning needs. To learn
more about how this team approach can help you serve your clients’ best interests, contact
an Edward Jones financial advisor today.
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Building a Team of Professionals
to Help Provide Solutions for Our Clients
At Edward Jones, we believe that when it comes to financial matters, the value of professional advice cannot
be overestimated. In fact, in most situations we recommend that clients assemble a team of professionals
to provide guidance regarding their financial affairs: an attorney, a tax professional and a financial advisor.
The legal, accounting and financial services industries are governed by constantly changing complex
laws and regulations; by working together as a team, driven by similar philosophies and guiding principles,
professionals in a variety of financial fields can use complementary knowledge and skills to assist mutual
clients in planning for today’s financial and tax challenges.
www.edwardjones.com/teamwork
This publication is for educational and informational purposes only. It is not intended, and should not be construed, as a specific
recommendation or legal, tax or investment advice. The information provided is for tax and legal professionals; it is not for use
with the general public. Edward Jones, its financial advisors and its employees cannot provide tax or legal advice; before acting
upon any information herein, individuals should consult a qualified tax advisor or attorney regarding their circumstances.
Edward Jones operates as an insurance producer in California, New Mexico, and Massachusetts through the following subsidiaries,
respectively: Edward Jones Insurance Agency of California, L.L.C., Edward Jones Insurance Agency of New Mexico, L.L.C., and
Edward Jones Insurance Agency of Massachusetts, L.L.C.
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CPA-5528D-A EXP 30 APR 2018